Valuation is political

In the right-wing backlash against environmental, social and governance (ESG) investing, everyone is accusing everyone else of placing politics over financial returns. The ESG vs anti-ESG debate has led various commentators to argue that ESG investing should be split into a purely risk-based strand, and an explicitly ethical strand.

Clarifying different meanings of ESG is a useful exercise, but it is questionable whether a purely risk-based approach to ESG, divorced from politics, is possible. In practice, valuation is never an objective and scientific undertaking. ESG or anti-ESG, in the age of climate change valuation is inherently political.

The ESG backlash has been driven by Republican-controlled states in the United States, which have sought to ban managers of state pension fund assets from considering ESG risks in their investments. Governor of Florida, Ron DeSantis, who passed a resolution to this effect in August, said that ESG investing was being used to “impose an ideological agenda on the American people.” The resolution, he said, was instead committed to “prioritizing the financial security of the people of Florida over whimsical notions of a utopian tomorrow.”

Asset managers have hit back against what they see at the politicisation of ESG, stressing that they are applying a strictly risk-based approach that is in line with their fiduciary duty. BlackRock was the only US-based fund to find itself on an anti-ESG list of financial companies that “boycott” fossil fuels released by the Texas Comptroller. BlackRock responded by saying that “politicising state pension funds, restricting access to investments, and impacting the financial returns of retirees, is not consistent with that duty.”

Commentators have suggested that this debate over risk vs politics can be addressed by formalising these as two separate strands of ESG investing. One strand is the purely risk-based approach that integrates ESG factors into valuation. The other is an explicitly ethical approach that uses investing to pursue ESG objectives.

Stuart Kirk, the former Head of Responsible Investment at HSBC Asset Management, who gave an infamous speech earlier this year arguing that the material financial risks of climate change were overstated, has advocated for this approach. Similar sentiments have been voiced by Ian Simm, who manages the environmental impact focused fund Impax Asset Management.

An upside of the ESG backlash is that it has created space for discussion about the blurry lines between ethical/sustainable/responsible/impact investing and ESG. Until recently, this discussion was muted by the outperformance of ESG funds, which made it appear that there was no trade-off between ‘doing good’ and ‘doing well’. Now, with rising interest rates and the war in Ukraine impacting the relative performance of ESG funds, the two strands of ESG suddenly appear in tension.

However, proposals to separate risk-based investing from the politics of ESG run into the problem that valuation is inescapably political.

On one level, valuation is political because fund managers themselves are not robots. They may have ‘hybrid motives’ spanning financial risk and political commitments that are difficult to disentangle, as Bloomberg’s Matt Levine has pointed out.

On a deeper level, valuation is political because financial risk itself is fundamentally shaped by politics. This key premise of ESG investing has been lost as fund managers seek to defend their risk-based investment approaches as a strategy solely for maximising returns.

Take, for example, the case of climate risk. The Task Force on Climate-Related Financial Disclosures makes clear that the biggest financial risk of climate change is not the ‘physical risks’ of extreme drought and rising sea levels, but ‘transition risk’.

‘Transition risk’ captures the financial risks created by future political responses to climate change. Valuing an asset through this prism requires political judgements about factors such as the stringency of future emissions targets, and the power of climate movements creating pressure on governments to act. The ‘fat tail’ of climate risk now includes the political risks of radical decarbonisation alongside abrupt tipping points.

Strategies of climate movements reveal dynamism in the political construction of climate risk. For example, activists are using litigation to put pressure on the corporate climate plans. Cases usually rest on an argument that firms or investors are inadequately pricing climate risk, but the strategy, in effect, is to make climate change a financially material risk. Lloyd’s and the Bank of England have recently warned that the threat of climate litigation is pushing up insurance premiums.

Assessment of these financial risks is political analysis. Kirk himself failed to recognise this in his infamous speech. Kirk’s argument rested too heavily on what he viewed as an objective assessment of the value of climate-exposed assets, without recognising that the extent of climate-related financial risk is, above all, a political question shaped by social and economic context.

The integration of ESG risks into valuation is political in a similar sense to Keynes’s famous description of financial market pricing as a newspaper beauty contest. Keynes argued that such decisions are made not on objective measures beauty, but rather perceptions of how others perceive average standards of beauty. While fund managers may bring their own political commitments on climate change to bear on valuation, far more significant is their view on how the market views the direction of climate politics.

Ironically, the right-wing backlash against ESG demonstrates that investment frameworks do not sit outside of this politics. Climate and other politics are increasingly being directed through investment frameworks. The Republicans seeking to ban ESG investing are no less participating in the risky politics of valuation than the fossil fuel divestment activist aiming to make ‘stranded assets’ a self-fulfilling prophesy. Both are actively constructing financial risk as a political battleground of climate change: the former is risking green; the latter is risking coal.

It is in this context that the rise of so-called ‘anti-ESG’ funds, which purport to offer a non-political investment option, should be understood. For example, anti-ESG campaigner Vivek Ramaswamy, of Strive Asset Management, has established a US Energy ETF that he claims has the “sole interest of maximising the value of our clients’ investment accounts, with no mixed motivation to also advance a social objective.” Yet, as the creative ticker for this (DRLL) and other similar funds (such as the MAGA and LYFE ETFs) make clear, they are, in practice, offering an alternative ESG investment strategy.

Clear-eyed asset managers will be integrating the emerging politics of ESG into their valuations, weighing the political currency of the ESG backlash against other political moves, such as efforts to enforce common ESG metrics to prevent greenwashing. While they will no doubt be attempting to maximise returns for their clients, they will also be playing their part in the politics of ESG risk.

Image source: Governor Ron DeSantis Facebook.